U.S. Stock Market - Is Another Flash Crash Possible?

Disclaimers usually come at the end in blogs like this one. However, given the title of this week's column, I think it's appropriate to let the reader know immediately and upfront that I have a substantial position in the double-short S&P 500 ETF (symbol SDS) in my largest managed account.

On the afternoon of May 6, 2010, the Dow Jones Industrial Average plunged approximately 600 points in about 5 minutes and was down almost 1,000 points (9%) intra-day before rebounding. There are dozens of theories about what happened that day and there were investigations by the SEC and the Chicago Mercantile Exchange, among others. As more than a casual observer at that time, I saw many similarities between the Flash Crash of May 2010 and the Black Monday Crash of October 1987. One common denominator was the so-called "tail wagging the dog" phenomenon involving the S&P 500 futures contract. When the near-term S&P 500 futures contract trades at a significant discount to the cash S&P 500 Index, arbitrageurs sell component stocks and then buy the futures in an attempt to lock in profits. Both crashes were marked by massive selling in the S&P 500 futures contract at discount prices to the cash index which then triggered massive liquidation of underlying component stocks which then cascaded into even more selling of futures and even greater liquidation of underlying component shares. The downside spirals that resulted were unprecedented in both cases. The October 19th Crash of 1987 saw the largest single day percentage decline in the history of the Dow Jones Industrial Average, 508 points or 23%. The May 6th Flash Crash of 2010 saw the largest intra-day point decline in the history of the Dow Jones Industrial Average, 999 points or 9%.

Is a "Flash Crash" like the one that unfolded on May 6th, 2010 possible today? 

The answer is yes, of course. However, given the recent widespread negative publicity for high frequency traders (HFT's), the odds are probably low. If another flash crash unfolded right now, HFT's would surely be blamed and the regulators would change the game forever (against them). While that may happen anyway, for now they are less likely to be involved if intra-day volatility suddenly ramps up.

If not a flash crash, then how about an '87-type crash? From the top on August 25th, 1987 to the bottom on October 19th, 1987, the S&P 500 Index fell 36% in 55 days, with most of the loss sustained on October 19th, the last day of this decline. Again, I don't think an '87-type crash will unfold here. The Federal Reserve and other major central banks will almost certainly intervene on any meaningful correction.

So where does that leave us? 

Remember Long Term Capital Management? In 1998, this infamous hedge fund lost $4.6 billion in less than four months on leveraged bets gone sour in Russia. The damage was so bad that the Federal Reserve actually brokered a $3.6 billion bailout on fears that a LTCM failure might take the whole system down (i.e. a Lehman-type event risk). From the S&P 500 peak in July 1998 to the low in October 1998, the S&P 500 dropped 22%. The players look eerily similar today to those back in 1998. Hedge funds are reeling right now with losses on their long positions in the high-fliers year-to-date so far. Russia is more than saber-rattling in Ukraine, and the G-7 is about to ratchet up sanctions against Putin. The Federal Reserve is trying to reign in its monetary accommodation known affectionately as QE, historically high corporate profit margins right now look vulnerable to me, and margin debt for stock purchases is now at a record. And to add insult to injury, the next five months are seasonally the worst period of the year to own stocks!

Bottom line: A stock market correction of at least 20% is forecast right now, just like the one that took place in 1998, between July and October of that year. 

U.S. Stock Market - Dow Jones Utility Average Sell Signal !

A Daily Chart Sell Signal was triggered at today's close in the Dow Jones Utility Average (see chart below). The yield on the 10-year T-note surged more than 8 basis points today to about 2.72%. While this level must still be consider low by historical standards, it was 1.61% in early May 2013 and bottomed out at 1.39% in late July 2012. In other words, the 10-year T-note yield has gone up 68% in less than one year and has almost doubled in less than two years. To add insult to injury, daily and weekly chart buy signals were triggered today in the double-short T-bond ETF (symbol TBT).

Dow Jones Utility Average with Computer-generated Buy & Sell Signals

So what does this all mean? If we listen to my computer system, then interest rates will soon be trending higher and T-note and T-bond prices will soon be trending lower. And today's sell signal in the Dow Jones Utility Average strongly suggests that stocks with high dividend yields should be liquidated by investors.

On a personal note, I have a fairly long commute to work everyday and my car is not a hybrid or electric powered. The price of gas is therefore a variable in my weekly budget. In Chicago, where I live, the price of regular gas has gone from $3.40/gallon to $4.20/gallon IN LESS THAN A MONTH! THAT'S A 24% INCREASE!! 

The following chart is borrowed from an article entitled "If The Smart Money Is Selling, Who's Buying?" as found on today's zerohedge.com website:

AAII Investor Asset Allocation History 1987 to Date

While this chart probably speaks for itself, it would appear to me that the average main street investor is loaded upon on stocks and has no more cash. Maybe this time is different, but this chart doesn't seem to bode well for stock prices. With mid-term and longer-term interest rates rising and gas prices squeezing family budgets, perhaps corporate profit margins (which have been at record highs) will also be squeezed?

In the interest of full disclosure, I significantly increased my position in the SDS double-short S&P 500 Index ETF in mid-afternoon trading today. Most major U.S. stock indexes have now been up for four days in a row, but today's last hour profit-taking was a key negative change in daily pattern. The Dow Jones Industrial Average actually posted a loss on the day today, along with the Dow Jones Utility Average. 

Bottom Line: The U.S. financial markets are closed tomorrow in observance of Good Friday, but next week is expected to be a nasty down week for stocks. And unlike earlier this week, when both the Nasdaq Composite Index and the Russell 2000 Index bounced nicely off their respective 200-day moving average lines, I don't believe that investors can expect the same kind of support the next time down. One particular stock market adage that his served me well over the years is: "First time bounce, second time trounce!"

U.S. Stock Market - Upside Reversal Day?

Just a quick note this evening following a volatile trading day in the U.S. Stock Market today.

The Nasdaq Composite Index and the Russell 2000 Index both bounced off their respective 200-day moving average lines, finished in plus territory after being sharply lower, and they also closed very near their best levels of the day. Please see attached charts below.

Daily chart buy signals were triggered by my computer trading system in several major stock indexes, ETF's, and dozens of beaten down tech stocks and so-called momentum "high flyers".

While I remain negative on the U.S. Stock Market, I thought it was important to let readers know that my computer trading system has signaled a short term "buy", which may result in a meaningful rebound in share prices over the next few days. My best forecast here is that any significant rally is "counter trend" and is therefore destined to fail.

 

Nasdaq Composite Index Daily Chart with 200-Day Moving Average Line & Computer Trading Signals

Russell 2000 Index Daily Chart with 200-Day Moving Average Line & Computer Trading Signals

U.S. Stock Market - Is There A Yellen Put?

Most major U.S. stock market averages were down sharply last week (about 3%). Many uninformed Wall Street pundits are describing this slide as "normal profit-taking" following an extraordinary advance over the last five years and from last year's exceptional rally in particular.

The $64,000 question for investors now is how do we determine if this latest pullback is merely a "correction" in an ongoing bull market or the beginning of a major new bear market? After almost 40 years of studying the markets, 9 years trading personal capital as a market maker on the CBOE, 10 years as editor and publisher of the Sutton Daily Advisory Letter, and 13 years managing money, I still don't have the answer to this question. And, quite honestly, there may not be a definitive answer. For me, however, I place a lot of trust in my computer trading system. I need to see weekly chart sell signals in most of the major averages and I need to see at least a few actual or preliminary monthly chart sell signals. For example, for the week ending January 24, 2014, weekly chart sell signals were triggered by my computer trading system in almost every major index (see the Russell 2000 Weekly Chart here). And now, preliminary monthly chart sell signals have already been triggered in several major indexes, and most of the other major indexes are close to triggering sell signals. And just in case nobody noticed, the Russell 2000 Index and the Nasdaq Composite Index BOTH crashed below their respective 150-day moving average lines on Friday, April 11th, for the first time since December 2012. It is my humble opinion that the 200-day moving average lines for both of these closely-watched benchmarks will provide equally feeble support for anyone who is still bullish. For me, the evidence is clear. A major new bear market is now underway!

Russell 2000 Index Weekly Chart with 30-week and 200-week Moving Average Lines

Russell 2000 Index Daily Chart with 150-day Moving Average Line

And what about the so-called "Yellen Put"? Over the last five years, the bullish case for stocks was bolstered by the fact that the Federal Reserve seemed to be there at every meaningful correction in the stock market with a new package of monetary stimulus (quantitative easing "QE") or Fed-friendly forward comments on the expected path of short term interest rates (Zero %, Aka "ZIRP", zero interest rate policy).

Like the former Chairman of the Federal Reserve (Ben Bernanke), investors can expect the new Chair Janet Yellen to provide support in the case of any serious decline in the U.S. stock market. Unfortunately for investors, the so-called "Yellen put" is probably significantly "out of the money" right now. In other words, the Federal Reserve will NOT be there for investors until and unless there is AT LEAST a 20% correction. Dovish "rhetoric" from Fed officials can be anticipated when the market corrects 10%, but the serious monetary accommodation (i.e. a whole new QE package) won't be presented until the "official" definition of a bear market is met with a decline of 20% or more.

My forecast from last week's column is repeated here:

The S&P 500 Index will retrace at least 50% of its last major bullish leg from October 2011 at 1074.77 to the record intra-day high recently posted at 1897.30. This would translate into a 21% correction to the 1486.04 level.

Attached below are the latest daily and monthly bar charts for the most popular ETF in the world, the S&P 500 Index ETF (symbol SPY). Both charts reflect all the buy and sell signals generated from my computer trading system. The latest monthly chart sell signal does not become official until April 30th. In the interest of full disclosure, I have a significant long position in the SDS "double short" S&P 500 ETF in one of my managed accounts.

Daily Chart of S&P 500 ETF (symbol SPY) with Computer Generated Buy & Sell Signals

Monthly Chart of S&P 500 ETF (symbol SPY) with Computer Generated Buy & Sell Signals

U.S. Stock Market - Nowhere To Hide !

On Friday, April 4th, the closely watched S&P 500 Index was down 1.25% on the day. Given its spectacular advance over the last five years of approximately 185%, this single-day loss hardly seems significant; not even a hiccup; and dare we say less than a pimple on an elephant's ass.

So why do we care?

It is sometimes said that "Bull markets take the stairs, while bear markets take the elevators!"

It is my view that the great bull market in U.S. stocks over the last five years has ended, and that stock investors are now stuck in the elevators on the very top floor of the tallest building in the world, with nowhere to go but down! And the ride down won't be friendly!!

Burj Khalifa Tower in Dubai

On March 9th in this column, I published a list of the 25 most overvalued stocks. This list was generated by a relatively simple, but effective, stock screening algorithm. Biotech shares were purposely eliminated from this list given the need for special metrics in that particular sector.

Here is that same list, with all the same names updated through April 4th, 2014:

The average stock on this list is now down 18.11% from its closing price on Friday, March 7th through the close of trade on Friday, April 4th. While this is a significant correction, what's really amazing to me is that the S&P 500 Index AND the Dow Jones Industrial Index both posted ALL-TIME record intra-day highs on Friday, April 4th ! How is possible that the so-called best-of-the-best high-flyers lost 18.11% while the most popular broad market benchmark indexes (SPX & DJIA) advanced to new all-time highs? In the interest of full disclosure, I do not have a position in any of the above-listed names, but I do have a very large position in the Double-Short Proshares S&P 500 ETF (symbol SDS). For every 1% drop in the S&P 500 Index, the double-short SDS ETF is expected to rise by 2%. Of course, if the S&P 500 should advance by 1%, the double-short SDS ETF would then fall 2%. There is no such thing as a free lunch. Make no mistake, you have to be right to win here with these leveraged ETF's, but I like the odds (especially with VIX implied volatility still less than 14).

In my view, there is nowhere to hide now for stock investors!

Even though the high-flyers have now corrected 18% in the last month and are down 24% from there recent all-time highs, they STILL trade at more than 100x forward 12-month earnings forecasts, and they are still priced at more than 10x sales. As predicted several times in previous columns here this year so far, I strongly believe that the above list of 25 names will be down at least 50%, on average, at one point this year.

While the high-flyers were collapsing over the last month, stock investors have sought refuge in the so-called "safe" big-cap names of the S&P 500 Index. Unfortunately for many investors, this defensive rotation has run its course and a major correction in the big-cap benchmark indices is now underway.

Daily chart sell signals were triggered within my computer trading system in the following indices at Friday's close, April 4th: DJIA, SPX, SPY, OEX, Oil Services Index (OSX), Oil Services ETF (OIH), Semiconductors Holders ETF (SMH), Airline Index (XAL), Communications Index (XTC), and the New York Composite Index. To add insult to injury for the bulls, a daily chart buy signal was triggered in the VIX and also the double-short SDS ETF at Friday's close.

Here are my two most probable scenarios for the rest of this year:

1. The S&P 500 Index retraces 50% of its complete 5-year bull market advance from its low in March 2009 at 666.80 to its all-time record intra-day high yesterday at 1897.30. The translates into a 32% correction to the 1282.05 level. 

2. The S&P 500 Index retraces 50% of its last major bullish leg from October 2011 at 1074.77 to yesterday's record intra-day high at 1897.30. This would translate into a 21% correction to the 1486.04 level.

Scenario #2 seems the most likely, of course, but I don't think you can rule out Scenario #1.

CASH IS KING !  NOWHERE ELSE TO HIDE !!

NY Composite Index Daily Chart with Computer-generated Buy & Sell Signals

S&P 500 Index with Computer-generated Buy & Sell Signals

NFLX Daily Bar Chart with 150-Day Moving Average Line